Question

Seether, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 41 percent debt. Currently, there are 1,700 shares outstanding, and the price per share is $65. EBIT is expected to remain at $17,500 per year forever. The interest rate on new debt is 9 percent, and there are no taxes.

  

Allison, a shareholder of the firm, owns 100 shares of stock. Suppose the company does convert, but Allison prefers the current all-equity capital structure. She could unlever her shares of stock to recreate the original capital structure by selling shares of stock and lending the proceeds at 9 percent.    Allison, a shareholder of the firm, owns 100 shares of stock. Suppose the company does convert, but Allison prefers the current all-equity capital structure. She could unlever her shares of stock to recreate the original capital structure by selling ---- shares of stock and lending the proceeds at 9 percent.

Answer 1

Answer:

EBIT = $17500

Price per share = $65

Number of shares outstanding = 1,700

Proposed capital structure is one that is 41 percent debt

The interest rate on new debt is = 9%

There are no taxes.

All Equity:

EPS = EBIT / Number of shares outstanding = 17500 / 1700 = $10.29412

Assuming 100% dividend payout ratio:

Allison's Cash flow = 100 * 10.29412 = $1,029.41

Proposed capital structure:

Since proposed capital structure has 41% debt:

EPS = (EBIT - Interest) / Number of shares outstanding

Total assets = 1700 * $65 = $110,500

Debt = 110500 * 41% = $45,305

Interest = 45305 * 9% = $4077.45

Number of shares repurchased = $45,305 / $65 = 697

Number of shares outstanding post repurchase = 1700 - 697 = 1,003

EPS = (17500 - 4077.45) / 1003 = $13.38240

As Allison wants previous capital structure (all equity), so to offset the borrowing the firm has made she has to lend money.

To lend money she need to sell shares.

Let us assume she sells X shares and lends money at 9%

The interest she will earn =65 * X * 9%

Now Allison's cash flow = (100 - X) * 13.38240 + 65 * X * 9%

The cash flow she earned from all equity firm =$1,029.41

Hence:

(100 - X) * 13.38240 + 65 * X * 9% = 1029.41

Solving this for X,

We get:

X = 41

Hence:

Allison, a shareholder of the firm, owns 100 shares of stock. Suppose the company does convert, but Allison prefers the current all-equity capital structure. She could unlever her shares of stock to recreate the original capital structure by selling 41 shares of stock and lending the proceeds at 9 percent.